##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-QSB

x
    
    QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the quarterly period ended September 30, 2003

Commission File Number 0-11447

DATAKEY, INC.
(Exact name of small business issuer as specified in its charter)

MINNESOTA
(State or other jurisdiction of
incorporation or organization)
    
    41-1291472
(I.R.S. Employer
Identification No.)


407 WEST TRAVELERS TRAIL, BURNSVILLE, MN 55337
(Address of Principal Executive Offices)

Issuers telephone number: (952) 890-6850



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Check whether the Issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the Issuer was required to file such reports) and (2) has
been subject to such filing requirements for the past 90 days.

Yes ü   No


APPLICABLE ONLY TO CORPORATE ISSUERS

The number of shares outstanding of the issuers common equity as of
October 31, 2003 is 11,729,773.

Transitional Small Business Disclosure Format (check One):

Yes    No ü






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|                                                                  |  |  |  |  |  |  |  | 
|----------------------------------------------------------------- |  |  |  |  |  |  |  | 
|BALANCE SHEETS                                                   
|STATEMENTS OF INCOME                                             
|STATEMENTS OF CASH FLOWS                                         
|NOTES TO FINANCIAL STATEMENTS                                    
|ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
|PART II. OTHER INFORMATION                                       
|SIGNATURES                                                       
|EXHIBIT INDEX TO FORM 10-QSB                                     
|EX-31.1 Certification of CEO - Section 302                       
|EX-31.2 Certification of CFO - Section 302                       
|EX-32.1 Certification of CEO - Section 906                       
|EX-32.2 Certification of CFO - Section 906                       



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PART I. FINANCIAL INFORMATION
ITEM I. FINANCIAL STATEMENTS
DATAKEY, INC.
BALANCE SHEETS

September 30,
    
    
    December 31,2003
    
    
    2002(UNAUDITED)ASSETSCURRENT ASSETSCash
    
    $
    397,384
    
    
    $
    2,562,611Trade receivables, less allowance for
doubtful accounts of $30,000 and $55,000
    
    
    1,139,648
    
    
    
    1,700,434Inventories, less reserves for obsolescence
of $181,000 and $164,000
    
    
    495,440
    
    
    
    996,532Prepaid expenses and other
    
    
    81,118
    
    
    
    65,259Total current assets
    
    
    2,113,590
    
    
    
    5,324,836OTHER ASSETSPatents at cost less amortization
    
    
    15,599
    
    
    
    0Prepaid licenses at cost less amortization
    
    
    373,141
    
    
    
    236,817of $335,229 and $309,183EQUIPMENT AND LEASEHOLD IMPROVEMENTS, at costProduction tooling
    
    
    30,230
    
    
    
    23,650Equipment
    
    
    724,487
    
    
    
    735,916Furniture and fixtures
    
    
    166,520
    
    
    
    166,520Leasehold improvements
    
    
    310,912
    
    
    
    310,9121,232,149
    
    
    
    1,236,998Less accumulated depreciation
    
    
    (1,042,738
    )
    
    
    (927,844
    )189,411
    
    
    
    309,154$
    2,691,741
    
    
    $
    5,870,807LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIESAccounts payable
    
    $
    380,390
    
    
    $
    574,266Accrued compensation
    
    
    296,241
    
    
    
    287,718Accrued expenses-other
    
    
    120,553
    
    
    
    154,267Deferred revenue
    
    
    422,726
    
    
    
    355,338Total current liabilities
    
    
    1,219,910
    
    
    
    1,371,589SHAREHOLDERS EQUITYConvertible preferred stock, voting, stated value
$2.50 per share; authorized 400,000 shares;
issued and outstanding 150,000
    
    
    375,000
    
    
    
    375,000Common stock, par value $.05 per share;
authorized 20,000,000 shares; issued and outstanding
10,129,773 in 2003 and 10,082,750 in 2002
    
    
    507,322
    
    
    
    504,138Additional paid-in capital
    
    
    18,982,012
    
    
    
    18,921,150Accumulated deficit
    
    
    (18,392,503
    )
    
    
    (15,301,070
    )1,471,831
    
    
    
    4,499,218$
    2,691,741
    
    
    $
    5,870,807


See Notes to Financial Statements

2



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DATAKEY, INC.
STATEMENTS OF INCOME
(UNAUDITED)

Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 28,
    
    
    September 30,
    
    
    September 28,2003
    
    
    2002
    
    
    2003
    
    
    2002Revenue
    
    $
    1,268,323
    
    
    $
    1,387,781
    
    
    $
    3,095,383
    
    
    $
    5,750,197Cost of goods sold
    
    
    601,874
    
    
    
    558,606
    
    
    
    1,775,625
    
    
    
    2,885,358Gross Profit
    
    
    666,449
    
    
    
    829,175
    
    
    
    1,319,758
    
    
    
    2,864,839Operating expenses:Research, development, technical support
and engineering
    
    
    468,231
    
    
    
    578,427
    
    
    
    1,534,035
    
    
    
    1,750,556Marketing and sales
    
    
    758,472
    
    
    
    762,878
    
    
    
    2,241,012
    
    
    
    2,439,904General and administrative
    
    
    111,110
    
    
    
    223,625
    
    
    
    646,482
    
    
    
    619,052Total operating expenses
    
    
    1,337,813
    
    
    
    1,564,930
    
    
    
    4,421,529
    
    
    
    4,809,512Operating loss
    
    
    (671,364
    )
    
    
    (735,755
    )
    
    
    (3,101,771
    )
    
    
    (1,944,673
    )Interest income
    
    
    1,482
    
    
    
    12,692
    
    
    
    10,338
    
    
    
    37,415Loss from continuing operationsbefore income taxes
    
    
    (669,882
    )
    
    
    (723,063
    )
    
    
    (3,091,433
    )
    
    
    (1,907,258
    )Income tax expense
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0Net loss from continuing operations
    
    
    ($669,882
    )
    
    
    ($723,063
    )
    
    
    ($3,091,433
    )
    
    
    ($1,907,258
    )Gain from disposal of discontinued segment
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    351,045Net loss
    
    
    ($669,882
    )
    
    
    ($723,063
    )
    
    
    ($3,091,433
    )
    
    
    ($1,556,213
    )Basic and diluted loss per share
from continuing operations
    
    
    ($0.07
    )
    
    
    ($0.07
    )
    
    
    ($0.31
    )
    
    
    ($0.19
    )Basic and diluted income per share
from discontinued operations
    
    $
    0.00
    
    
    $
    0.00
    
    
    $
    0.00
    
    
    $
    0.04Basic and diluted
loss per share
    
    
    ($0.07
    )
    
    
    ($0.07
    )
    
    
    ($0.31
    )
    
    
    ($0.15
    )Weighted average number of common
shares outstanding-basic and diluted
    
    
    10,128,820
    
    
    
    10,082,750
    
    
    
    10,122,936
    
    
    
    10,072,138


See Notes to Financial Statements

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DATAKEY, INC.
STATEMENTS OF CASH FLOWS
(UNAUDITED)

Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 28,
    
    
    September 30,
    
    
    September 28,2003
    
    
    2002
    
    
    2003
    
    
    2002CASH FLOWS FROM
OPERATING ACTIVITIESNet loss
    
    
    ($669,882
    )
    
    
    ($723,063
    )
    
    
    ($3,091,433
    )
    
    
    ($1,556,213
    )Adjustments to reconcile net loss
to net cash used in operating activities:Depreciation
    
    
    46,390
    
    
    
    56,701
    
    
    
    136,840
    
    
    
    119,436Amortization
    
    
    10,690
    
    
    
    21,799
    
    
    
    26,046
    
    
    
    75,457Change in assets and liabilities(Increase) decrease in assets:Trade receivables
    
    
    (210,986
    )
    
    
    212,002
    
    
    
    560,786
    
    
    
    668,692Inventories
    
    
    79,618
    
    
    
    49,225
    
    
    
    501,092
    
    
    
    (93,267
    )Prepaid expenses and other
    
    
    5,413
    
    
    
    (82,093
    )
    
    
    (15,859
    )
    
    
    (42,755
    )Increase (decrease) in:Accounts payable
    
    
    56,250
    
    
    
    39,090
    
    
    
    (193,876
    )
    
    
    (138,410
    )Accrued expenses
    
    
    34,793
    
    
    
    171,168
    
    
    
    (25,191
    )
    
    
    173,282Deferred revenue
    
    
    3,814
    
    
    
    (127,119
    )
    
    
    67,388
    
    
    
    (242,565
    )Net cash used in
operating activities
    
    
    (643,900
    )
    
    
    (382,290
    )
    
    
    (2,034,207
    )
    
    
    (1,036,343
    )CASH FLOWS FROM INVESTING ACTIVITIESCash paid for patents and licenses
    
    
    (35,379
    )
    
    
    (21,799
    )
    
    
    (177,969
    )
    
    
    (75,457
    )Purchase of equipment and leasehold improvements
    
    
    (373
    )
    
    
    (1,653
    )
    
    
    (17,097
    )
    
    
    (71,676
    )Net cash used in
investing activities
    
    
    (35,752
    )
    
    
    (23,452
    )
    
    
    (195,066
    )
    
    
    (147,133
    )CASH FLOWS FROM FINANCING ACTIVITIESNet proceeds from issuance of
common stock
    
    
    13,079
    
    
    
    0
    
    
    
    64,046
    
    
    
    346,298Net cash provided by financing activities
    
    
    13,079
    
    
    
    0
    
    
    
    64,046
    
    
    
    346,298Decrease in cash
    
    
    (666,573
    )
    
    
    (405,742
    )
    
    
    (2,165,227
    )
    
    
    (837,178
    )CASHBeginning
    
    
    1,063,957
    
    
    
    3,680,828
    
    
    
    2,562,611
    
    
    
    4,112,264Ending
    
    $
    397,384
    
    
    $
    3,275,086
    
    
    $
    397,384
    
    
    $
    3,275,086


See Notes to Financial Statements

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DATAKEY, INC.
NOTES TO FINANCIAL STATEMENTS

Note 1. NATURE OF BUSINESS
Datakey, Inc. provides products and systems directed to the information
security market, which enables user identification and authentication, secure
data exchange and information validation. In 2000 the Company discontinued a
segment which provided electronic products, consisting of proprietary memory
keys, cards and other custom-shaped tokens. Such products served as a
convenient way to carry electronic information and were packaged to survive in
portable environments.

Note 2. BASIS OF PRESENTATION
In the opinion of management, the accompanying unaudited financial statements
contain all adjustments necessary to present fairly Datakeys financial
position as of September 30, 2003, and December 31, 2002, and results of its
operations and cash flows for the three-month and nine-month periods ended
September 30, 2003, and September 28, 2002. The adjustments that have been
made are of a normal recurring nature.

The accounting policies followed by the Company are set forth in Note 1 to the
Companys financial statements in the 2002 Datakey, Inc. Annual Report and in
Form 10-KSB for the year ended December 31, 2002.

Note 3. SOFTWARE DEVELOPMENT COSTS
The Companys policy is to expense those costs of software development incurred
until the point of technical feasibility is attained, at which time such costs
are capitalized. No amounts have been capitalized due to uncertainties about
the market acceptance of the underlying products.

Note 4. STOCK BASED COMPENSATION
The Company regularly grants options to its employees under various plans. As
permitted under accounting principles generally accepted in the United States
of America, these grants are accounted for following APB Opinion No. 25 and
related interpretations. Accordingly, compensation cost has been recognized for
those grants whose exercise price is less than the fair market value of the
stock on the date of grant. No compensation expense recorded for employee
grants for the quarters ended September 30, 2003 and September, 2002.
Compensation expense recorded for employee grants for the nine-month periods
ended September 30, 2003 and September 28, 2002 was $4,546 and $0,
respectively. The Company also periodically grants options and warrants to
non-employees for goods and services and in conjunction with certain
agreements. These grants are accounted for under FASB Statement No. 123 based
on the grant date fair values.

Had compensation cost for all of the stock-based compensation grants and
warrants issued been determined based on the fair values at the grant date
consistent with the provisions of Statement No. 123, the Companys net loss and
net loss per basic and diluted common share would have been as indicated below.

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September 30,
    
    
    September 28,Quarters Ended
    
    2003
    
    
    2002Net loss, as reported
    
    
    ($669,882
    )
    
    
    ($723,023
    )Deduct total stock-based employee
compensationexpense determined under the fair value-
based method for all awards
    
    
    (149,383
    )
    
    
    (192,196
    )Net loss, pro forma
    
    
    ($819,265
    )
    
    
    ($915,209
    )Basic and diluted loss per share, as reported
    
    
    ($.07
    )
    
    
    ($.07
    )Basic and diluted loss per share, pro forma
    
    
    ($.08
    )
    
    
    ($.09
    )


September 30,
    
    
    September 28,Nine Month Periods Ended
    
    2003
    
    
    2002Net loss, as reported
    
    
    ($3,091,433
    )
    
    
    ($1,556,213
    )Deduct total stock-based employee
compensationexpense determined under the fair value-
based method for all awards
    
    
    (498,103
    )
    
    
    (558,208
    )Net loss, pro forma
    
    
    ($3,589,536
    )
    
    
    ($2,114,421
    )Basic and diluted loss per share, as reported
    
    
    ($.31
    )
    
    
    ($.15
    )Basic and diluted loss per share, pro forma
    
    
    ($.35
    )
    
    
    ($.21
    )


The above pro forma effects on net loss and net loss per basic and diluted
common share are not likely to be representative of the effects on reported net
loss or net loss per common share for future years because options vest over
several years and additional awards generally are made each year.

Note 5. PRODUCT WARRANTY
The Company provides a limited 90-day warranty for the replacement of defective
products. The Companys standard warranty policy requires the Company to repair
or replace defective products at no cost to its customers. The Company
estimates the costs that may be incurred under its basic limited warranty and
records a liability in the amount of such costs at the time product revenue is
recognized. Factors that affect the Companys warranty liability include the
number of units sold, historical and anticipated rates of warranty claims, and
cost per claim. The Company periodically assesses the adequacy of its recorded
warranty liabilities and adjusts the amounts as necessary. The Company utilizes
historical trends and information received from its customers to assist in
determining the appropriate loss reserve levels. The warranty accrual was
reduced in late 2002 to reflect the occurrence of fewer warranty claims.

Changes in the Companys warranty liability are as follows:

Three Months Ended Sep. 30,
    
    
    Nine Months Ended Sep 30,2003
    
    
    2002
    
    
    2003
    
    
    2002Balances, Beginning of period
    
    $
    3,425
    
    
    $
    25,641
    
    
    $
    4,175
    
    
    $
    26,894Accruals for products sold
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0Payments made
    
    
    681
    
    
    
    220
    
    
    
    1,431
    
    
    
    1,473Balances, End of period
    
    $
    2,744
    
    
    $
    25,421
    
    
    $
    2,744
    
    
    $
    25,421


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Note 6. LICENSES
Licenses are stated at cost. The costs of the license agreements are amortized
to cost of goods sold as the products incorporating the licensed units are
sold. Under these agreements, the Company generally agrees to purchase a
minimum quantity of software units over a specified period of time.

Licenses:
    
    September 30, 2003
    
    
    December 31, 2002Gross carrying amount
    
    $
    708,370
    
    
    $
    546,000Accumulated amortization
    
    
    (335,229
    )
    
    
    (309,183
    )Net carrying amount
    
    $
    373,141
    
    
    $
    236,817


Aggregate amortization expense is as follows:

Quarter ended September 30, 2003
    
    $
    10,690Quarter ended September, 2002
    
    $
    21,799Nine months ended September 30, 2003
    
    $
    26,046Nine months ended September 28, 2002
    
    $
    75,457Year ended December 31, 2002
    
    $
    182,847


The Company expects that the carrying amount of the license agreements will be
charged to amortization in 2003 and 2004 based upon the expected sales of its
products which incorporate the licenses. In 2002, the Company entered into a
license agreement, and amended the agreement in 2003, under which it purchased
licenses for $195,000 and agreed to minimum future purchase of licenses for
$325,000 by March 2004. The Company presently expects to acquire and utilize
the minimum number of licenses under the agreement by the end of 2004.

The Company reviews its license costs for impairment and records impairment
charges if sales of products incorporating the licenses are less than expected.
As a result, the Company recognized no impairment expense during the quarter
ended September 30, 2003, $12,167 during the quarter ended September 28, 2002
and $48,667 for the year ended December 31, 2002 to reduce the carrying amount
of certain license costs to the amount required based on sales levels. These
impairment charges are included in the caption cost of goods sold in the
accompanying income statement.

Note 7. RECENT ACCOUNTING PRONOUNCEMENTS

The Financial Accounting Standards Board (FASB) has issued Statement No. 150,
Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. Statement No. 150 requires that certain freestanding
financial instruments be reported as liabilities in the balance sheet.
Depending on the type of financial instrument, it will be accounted for at
either fair value or the present value of future cash flows determined at each
balance sheet date with the change in that value reported as interest expense
in the income statement. Prior to the application of Statement No. 150, either
those financial instruments were not required to be recognized, or if
recognized were reported in the balance sheet as equity and changes in the
value of those instruments were normally not recognized in net income. The
Company has applied Statement No. 150 for the quarter ended September 30, 2003.

Statement No. 150 had no effect on reported results in the quarter ended
September 30, 2003 and the Company does not expect the application of Statement
No. 150 to have a material effect on its future financial statements.

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Note 8. SUBSEQUENT EVENTS-FINANCING OBTAINED
On October 17, 2003 the Company closed on a $2 million convertible secured loan
with a group of accredited investors. The note has a term of 12 months, is
secured by all assets of the Company and is convertible into common stock at a
price of $1.25. In addition the investors were granted 4 million warrants with
a term of seven years and an exercise price of $.77.

During September, 2003 the Company reduced the exercise price to $.70 on
1,600,000 warrants originally issued in February, 2001. Additionally, in
October, 2003 offered new warrants at an exercise price of $.77 as an
additional incentive for warrant holders to exercise their warrants. All
warrant holders accepted either the September offer to exercise at $.70 or the
October offer to exercise at $.70 and to receive new warrants with a term of
five years and an exercise price of $.77 providing a total of $1,120,000 to the
Company.

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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONDATAKEY, INC.

RESULTS OF OPERATIONS
CONTINUING OPERATIONS

REVENUE
Revenue for the three-month period ended September 30, 2003 decreased by
$119,000, or 9 percent, as compared to the same period in 2002. Revenue for
the nine-month period ended September 30, 2003 decreased by $2,655,000, or 46
percent, as compared to the same period in 2002. The significant decrease in
revenue in the three-month and nine-month periods, compared to the 2002
periods, resulted primarily from a reduction in demand for our products created
by the slowdown in IT spending and budgetary issues. Revenue for the quarter
ended September 30, 2003 increased by $235,000, or 23 percent, from the quarter
ended June 30, 2003 as the Companys customers continue to show more
willingness to place orders for IT security. Although it is too early to
determine if this trend will continue long-term, the Company believes that
revenue in the 2003 fourth quarter will exceed the level attained in the 2003
third quarter.

GROSS PROFIT MARGIN
Gross profit, as a percentage of revenue, decreased to 53 percent and 43
percent in the three-month and nine-month periods, respectively, ended
September 30, 2003, from 60 percent and 50 percent in the three-month and
nine-month periods, respectively, ended September 28, 2002. The decrease in
gross profit percentage in the three-month and nine-month periods related
primarily to fixed overhead being spread over the reduced revenue.

OPERATING EXPENSES
Operating expenses decreased by $227,000 in the three-month period and $388,000
in the nine-month period ended September 30, 2003, primarily as the result of a
reduction in personnel and discretionary expenditures offset by accruals, in
the amount of $278,000, during the first quarter of 2003, for severance pay and
other expenses related to a reduction in staff. Operating expenses during the
fourth quarter of 2003 are expected to increase modestly from the third
quarter.

INTEREST INCOME
Interest income, net of a minor amount of interest expense, decreased to $1,000
and $10,000 in the three-month and nine-month periods ended September 30, 2003
from $13,000 and $37,000 in the three-month and nine-month periods ended
September 28, 2002, reflecting a lower rate of interest and a reduction in
cash.

OUTLOOK
The worldwide slowdown in IT spending in the commercial market as well as in
the government market continues. Although we are beginning to see a gradual
improvement in orders as evidenced by the improved financial results in the
third quarter and a slightly more positive attitude about future orders when
communicating with customers, we are unable to determine when or if a
measurable increase in orders will occur. Accordingly, we are not providing
revenue guidance at this time.

LIQUIDITY AND FINANCIAL CONDITION
The Company experienced a decrease in cash of $667,000 in the three-month
period ended September 30, 2003. The decrease in cash during the three-month
period related to the operating loss, a $211,000 increase in accounts
receivable and a $26,000 increase in prepaid license fees. The cash decrease
was offset by a $80,000 decrease in inventory and a $95,000 increase in
accounts payable, accrued expenses and deferred revenue. The statements of
cash flows include discontinued operations as well as continuing operations in
the 2002 periods.

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Accounts receivable increased $211,000 during the three-month period ended
September 30, 2003 primarily as a result of an increase in revenue in the
quarter ended September 30, 2003 compared to the quarter ended June 30, 2003.
Inventory decreased by $80,000 during the three-month period ended September
30, 2003 as the Company curtailed inventory purchases in light of cash
limitations.

Datakeys balance sheet reflects $894,000 in working capital as of September
30, 2003 and a current assets to current liabilities ratio of 1.7 to 1. The
Company believes that its current level of cash, including $1,120,000 in cash
from warrant exercises and $2,000,000 from a secured loan in early October,
will provide sufficient liquidity to fund operations for at least one year.

In order to maintain the listing of its Common Stock on the Nasdaq Stock
Market, the Company must meet certain financial tests (including, but not
limited to, a minimum bid price of our Common Stock of $1.00 and a minimum net
worth of $2,500,000). As of June 30, 2003, the Company no longer met such
minimum net equity requirement or alternative requirements and was notified by
Nasdaq Staff that the Company was subject to delisting. The Company appealed
the staff determination and presented a plan to become compliant and to
maintain compliance. Because the Company was unsuccessful in raising
additional equity financing, under favorable terms, necessary to maintain
listing compliance the Company withdrew its appeal and accepted delisting. The
Companys stock began trading on the OTC Bulletin Board on November 13, 2003.

CONTRACTUAL CASH OBLIGATIONS
At September 30, 2003 the Company had no long-term debt outstanding and its
contractual cash obligations are those from minimum payments under a software
license agreement and operating lease obligations. As discussed in Note 8 to
the financial statements, on October 17, 2003 the Company closed on a
$2,000,000 convertible note with a term of 12 months. Repayment of this note
is included in the 2004 obligations in the table below:

2003
    
    $
    154,000
    
    (remaining three months)2004*
    
    
    2,237,0002005
    
    
    22,000thereafter
    
    
    10,000


*The lease on the Companys primary facility expires June 30, 2004.

OPERATING SEGMENTS
Through July 31, 2001, the Company had two reportable segments: Electronic
Products (EP) and Information Security Solutions (ISS). As discussed in the
following notes, the EP segment has been shown as discontinued operations
beginning in December 2000. The Electronic Products segment produced and
marketed proprietary memory keys, cards, and custom-shaped tokens and systems
that utilize these products that serve as a convenient way to carry electronic
information. The assets related to the ongoing business of the EP business
segment were sold in August 2001 and the final EP contract was fulfilled in
2002. The Information Security Solutions segment produces and markets products
for the information security market, which enable user identification and
authentication, secure data exchange, and information validation.

The accounting policies of the segments are the same as those described in the
summary of significant accounting policies described in our Form 10-KSB. There
are no inter-segment transactions. The Company evaluates performance based on
operating earnings of the respective segments.

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Three Months Ended September 30, 2003
    
    
    Nine Months Ended September 30, 2003EP
    
    
    ISS
    
    
    UNALLOCATED
    
    
    TOTAL
    
    
    EP
    
    
    ISS
    
    
    UNALLOCATED
    
    
    TOTALRevenue
    
    $
    0
    
    
    $
    1,268,323
    
    
    
    
    
    
    $
    1,268,323
    
    
    $
    0
    
    
    $
    3,095,383
    
    
    $
    
    
    
    $
    3,095,383Interest income
(expense)
    
    
    
    
    
    
    
    
    
    
    1,482
    
    
    
    1,482
    
    
    
    
    
    
    
    
    
    
    
    10,338
    
    
    
    10,338Depreciation and
amortization
    
    
    0
    
    
    
    57,080
    
    
    
    
    
    
    
    57,080
    
    
    
    0
    
    
    
    162,886
    
    
    
    
    
    
    
    162,886Segment profit (loss)
    
    
    0
    
    
    
    (671,364)
    )
    
    
    1,482
    
    
    
    (669,882
    )
    
    
    0
    
    
    
    (3,091,433
    )
    
    
    10,338
    
    
    
    (3,091,433
    )


Three Months Ended September 28, 2002
    
    
    Nine Months Ended September 28, 2002EP
    
    
    ISS
    
    
    UNALLOCATED
    
    
    TOTAL
    
    
    EP
    
    
    ISS
    
    
    UNALLOCATED
    
    
    TOTALRevenue
    
    $
    0
    
    
    $
    1,387,781
    
    
    
    
    
    
    $
    1,387,781
    
    
    $
    870,051
    
    
    $
    5,750,197
    
    
    $
    
    
    
    $
    6,620,248Interest income
(expense)
    
    
    
    
    
    
    
    
    
    
    12,692
    
    
    
    12,692
    
    
    
    
    
    
    
    
    
    
    
    37,415
    
    
    
    37,415Depreciation and
amortization
    
    
    0
    
    
    
    63,422
    
    
    
    
    
    
    
    63,422
    
    
    
    0
    
    
    
    194,893
    
    
    
    
    
    
    
    194,893Segment profit (loss)
    
    $
    0
    
    
    
    (735,755
    )
    
    
    12,692
    
    
    
    (723,063
    )
    
    
    351,045
    
    
    
    (1,944,673
    )
    
    
    37,415
    
    
    
    (1,556,213
    )


DISCONTINUED OPERATIONS
In February 2001 the Companys Board of Directors approved managements plan to
discontinue the operations of the EP segment. The plan anticipated the phase
down of the operations through December 31, 2001, although the Company
continued to pursue the possibility of selling the operations.

The estimated loss, taken in 2000, on the phase down of the EP segment included
the write-off of inventory, patents, and equipment anticipated to remain at the
date of closedown and expenses associated with the phase down, net of estimated
operating income through that date. The phase down of the segment was
accounted for as discontinued operations and, accordingly, its net assets and
net liabilities have been segregated from continuing operations in the balance
sheets and the results of operations have been excluded from continuing
operations for all periods presented. There were no net assets of the EP
segment as of June 30, 2003 and December 31, 2002.

SALE OF DISCONTINUED BUSINESS SEGMENT
On August 3, 2001, the Company completed the sale of the EP business segment
fixed assets, inventory, patents and prepaid expense along with customer lists,
assignment of certain customer contracts and all intellectual property required
to operate the EP business segment. The Company retained certain customer
contracts, and all EP accounts receivable, accounts payable and accrued expense
as of July 31, 2001

Under terms of the primary contract retained upon sale of the EP segment, the
customer was required to provide certain components that were necessary to
complete the manufacture and shipment of the final product, provide necessary
test fixtures and also was required to approve the final test results prior to
shipping the product. Due to a delay in delivery of the customer provided
materials and a delay in providing the necessary test fixtures, the completion
date of the contract extended beyond the date that was initially expected at
the time the EP segment was sold.

During the second quarter of 2002, the Company completed the final delivery
under the contract retained at the time of sale of the EP segment and realized
a profit of $361,767. This amount was reflected on the Income Statement as
gain on disposition of discontinued operation. This completed the sale of the
EP segment and no further gain or loss from discontinued operations is
expected.

FORWARD LOOKING STATEMENTS

Certain statements in the Managements Discussion and Analysis are
forward-looking statements that involve a number of risks and uncertainties
that may cause the Companys future operations and results of operations to
differ materially from those anticipated in this report. Specifically, these
include statements relating to the sufficiency of capital for at least one year
and the expected increase in revenue in the fourth quarter versus the third
quarter of 2003, both of which depend on the ultimate demand for Company
products given the overall

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slowdown in the IT security industry, the extent to which the IT security
market recovers, the success of the Companys new product, Axis, the Companys
ability to continue to control expenses, as well as general competitive, market
and economic conditions.

ITEM 3. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, the Company conducted an
evaluation under the supervision and with the participation of the companys
management, including the Companys Chief Executive Officer and Chief Financial
Officer, regarding the effectiveness of the design and operation of the
Companys disclosure controls and procedures pursuant to Rules 13a-15(b) of the
Securities Exchange Act of 1934 (the Exchange Act). Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Companys disclosure controls and procedures are effective to ensure
that information that is required to be disclosed by the Company in reports
that it files under the Exchange Act is recorded, processed, summarized and
reported within the time period specified in the rules of the Securities
Exchange Commission.

There were no changes in the Companys internal control over financial
reporting that occurred during the period covered by this report that have
materially affected, or are reasonably likely to materially affect, the
Companys internal control over financial reporting.




PART II. OTHER INFORMATION

ITEM 5.
See note below under Item 6(b) relating to Nasdaq listing status.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
     (a) Exhibits

See Exhibit Index following Certifications

(b) Reports on Form 8-K

A Form 8-K dated July 31, 2003 was filed announcing the financial results
for the quarter ended July 31, 2003 and announcing that the Company had
received a notice of potential delisting from Nasdaq for failure to meet
the $1 minimum bid price rule. A Form 8-K was filed on September 26, 2003
to announce that the Company had received a Nasdaq Staff Determination
Letter regarding delisting from the Nasdaq SmallCap Market, both due to
the failure to meet the minimum bid price and minimum net worth
requirements. Subsequently, the Company requested an oral hearing with
respect to such delisting, and such hearing was held on October 23, 2003.
On November 11, 2003, the Company withdrew its appeal of the delisting and
began to trade on the OTC Bulletin Board on November 13, 2003.

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SIGNATURES



In accordance with the requirements of the Exchange Act of 1934, the Registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

Dated: November 14, 2003
    
    Datakey, Inc.By:
    
    /s/ Timothy L. RussellTimothy L. Russell
Chief Executive Officer
(Principal Executive Officer)By:
    
    /s/ Alan G. ShulerAlan G. Shuler
Vice President & Chief Financial Officer
(Principal Financial and Accounting Officer)


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##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549




EXHIBIT INDEX TO FORM 10-QSB

For the fiscal quarter endedSeptember 30, 2003
    
    Commission File No. 0-11447




---



DATAKEY, INC.



---



Exhibit No.
    
    Description31.1
    
    Certification of Chief Executive Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification of Chief Financial Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certification of Chief Executive Officer under §906 of the Sarbanes-Oxley
Act of 200232.2
    
    Certification of Chief Financial Officer under §906 of the Sarbanes-Oxley
Act of 2002


14